Something will at some point, but the most plausible downside scenarios still look like a stretch for this year and next.
Markets may not be priced for perfection, but they don’t look like they can stand too much bad news, with Investment Grade spreads tighter than at any point since 2005 and the S&P 500 trading at price-to-earnings ratios above 20 times. Maybe, just maybe, valuations are stretched because the risks are actually lower for now. Growth is very strong, inflation still looks temporary, and the Fed has our backs.
But even typing these words sends chills down my spine and now requires a cold-eyed review of just what might cast these markets into a tumble. I count seven possibilities, but, to be honest, none looks threatening enough today to keep me up tonight.
- Inflation Risk I, Shrinking Supply: For decades, price pressures have moderated as globalization brought a vast new supply of workers into the market and production technologies have expanded the supply of everything from oil to shoes to telecommunication services. Now, on the labor side, has the pandemic driven America’s baby boomers into retirement and forced career reassessments that will shrink the number of available workers and drive wages higher? It’s possible, but I’d be surprised if they have all left the labor force forever. On the goods side, will the desire for more resilient supply chains closer to home drive up costs? Maybe for some crucial medical supplies, but we’re hardly likely to see all furniture and toy manufacturing return to the United States.
- Inflation Risk II, Rising Demand: The biggest difference between the pre-pandemic and the post-pandemic economies is government attitudes toward spending. Can you imagine an ambitious future U.S. candidate getting traction without promising at least a trillion dollars for some new priority? If there was one thing the G7 governments agreed on at their recent summit, it was the need to spend more: on reinforcing infrastructure, on addressing climate change, and on redressing inequality. This last target will be especially important to watch, because higher transfers to poorer households will create an additional step up in demand and just might—might—support a continuous rise in prices. But this depends on much more than the infrastructure package inching forward in Washington; it will come in the form of social transfers for education, housing, and health care that get baked into the system and that neither party will have the stomach to cut. It’s worth watching, but it’s not this (or next) year’s worry.
- Monetary Policy Mistake: For all the talk of inflation, there are clearly still worries of deflation. Yields actually fell when the Fed signaled the smallest of steps toward policy normalization last week. Again, it’s hard to believe we are tightening too soon, given the strong data and generous fiscal outlook.
- Financial Excess: There’s plenty to behold, from Archegos to Greensill to GameStop, but so far it’s still difficult to see anything on this scale cascading through a banking system that is much better capitalized and regulated than before. Of course, there are lots of interconnections within the non-banking system that could spread risks, and the recent policy response is sure to deliver unwelcome and unintended consequences somewhere. Still, it’s hard to see these spreading (for now) through corporations and households with mostly robust balance sheets.
- New COVID Variants: They’re worrying, of course, but the vaccines are still impressive, and extensive lockdowns seem possible only under extreme circumstances.
- Geopolitical Crisis: You name it! Rising tensions in the Middle East, missile tests in North Korea, or Something Else Really Bad Happening Somewhere! Tensions between the U.S. and China seem sure to get worse with more sanctions, export controls, and “strongly worded statements.” After a week or two of heightened anxiety, though, investors usually see that the risks to their expected cash flows are still relatively distant.
- Cyberattack: OK, this one does keep me up a lot of nights. A virus that threatens the world’s largest businesses and their data systems would be the electronic equivalent of COVID-19. Is your investment safe? Are you sure? But, as frightening as the prospect may be, it’s still too theoretical for markets to price properly.
These hazards are all very real, and there are surely others that we have yet to imagine. But maybe, just maybe, if markets are so handsomely priced, it’s because the downside risks are a little harder to envision over the next year or two, given the economy’s current momentum. For now, the best we can do is keep watch and enjoy what looks like a broad and durable recovery.
INVESTMENT GRADE SPREADS
Source: Bloomberg. As of June 24, 2021.
S&P 500 PE RATIOS
Source: Bloomberg. As of June 24, 2021.